Question

Read the article The Dangers of Deflation from The Economist; the article is available as a pdf file under "Articles" on the Blackboard menu.

Respond to the following questions:

a) What are the dangers of deflation?
b) What can be said about "monetary neutrality" in the context of a low inflation environment?
c) Drawing on what you have learned in recent chapters (29, 30), what recommendations would you make to policy makers in a situation of very low inflation or deflation?
d) What, in your opinion, is the appropriate policy response of the Federal Reserve?

The dangers of deflation

The pendulum swings to the pit

Politicians and central bankers are not providing the world with the inflation it needs; some economies face damaging deflation instead

Oct 25th 2014 | WASHINGTON, DC

IT IS a pernicious threat, all the more so because, at its onset, it seems almost benign. After two generations of fighting against inflation, why be worried if the victory looks just a bit too complete, if the ancient enemy is so cowed as to no longer strain against the chains in which it is bound? But the stable low inflation fought for in the 1980s and 1990s and inflation hazardously close to zero are not so far apart. And as inflation drops, slipping into deflation becomes ever easier. It is in that dangerous position that the world now stands.

In America, Britain and the euro zone central banks have a 2% target for inflation. In all three, it is below that target. In Italy, Spain and Greece, which have experienced wrenching crises and recessions, it is below zero (as it also is in Sweden and Israel). Japan, which finally escaped from deflation in 2013 after more than a decade of struggle, is battling not to return. Leave out the effects of a consumption-tax increase and inflation there is barely half way to its 2% target. Even in China inflation is below 2%, compared with a 4% central government

target (see chart 1).

The lowflation of being consistently below an already low target is bad in itself; the deflation it could easy lead to is even worse. There are several reasons. The belief that money made tomorrow will be worth less than money today stymies investment; the belief that goods bought

tomorrow will be cheaper than goods bought today chokes consumption. Central bankers can no longer set real (that is, inflation-adjusted) interest rates low enough to restore demand. Wages, incomes and tax revenue all stall, undermining the ability of households, businesses and governments to pay their debts—debts which, in real terms, will grow more burdensome under deflation.

The threat is especially acute because central banks in much of the rich world have already lowered their interest rates to zero. Alternative paths to stimulate spending, such as fiscal policy, are blocked by politicians seeking to look tough. Increasing anxiety about this was a central factor in the plunge in equities, bond yields and commodity prices which shook markets in the week that began October 13th.

The perversity of the low-inflation world is shown by the fact that the catalyst for the latest deflation scare is in itself a largely positive development. The price of a barrel of oil has fallen from $115 at the end of June to about $85 today, prompting a sharp drop in headline inflation (core inflation, which excludes energy, is not quite as low). Across the board lower commodity prices will knock another 0.4 percentage points off global inflation in coming months, according to J.P. Morgan.

This poses problems for various oil exporters (see article) but for oil importers it is tantamount to a gigantic tax cut. An IMF rule of thumb has it that a $20 drop in the oil price adds about 0.4 percentage points to global growth.

A descent into the maelstrom

But let joy be confined. The drop in oil prices is in part due to higher supply, but it is also the product of slowing growth around the world.China’s slackened appetite for raw materials has hit emerging-market commodity suppliers particularly hard. And an energy-induced drop in prices, though good for consumer purchasing power, risks reinforcing expectations of lower inflation overall; it is part of the threat’spernicious nature that such expectations easily become self-fulfilling.

In recent months investors have lost faith in either the ability or the will of central banks to get inflation rates back up. The inflation rate they expect can be inferred by looking at derivatives contracts linked to inflation or by subtracting the yields of inflation-indexed bonds from yields on ordinary, nominal, bonds. The spread represents expected inflation in coming years.

Answer 1

Solution A

Deflation has many dangers as The belief that goods purchased Tommorow shall be more cheaper than today certainly blocks consumption. Also wages, Incomes and Tax revenues come to halt consequently. Also debt repayment fot government and corporate becomes complex.

Solution B

Monetary neutrality generally fails to lift deflation even when increasing money supply in market cannot lift inflation to targeted level. Since monetary neutrality assumes change in money supply changes the prices og goods, in this case deflation does not get affected as seen in todays world even with rising fiscal stimulus or low interest rates.

Solution C

In situations like deflation, government can provide for unemployment insurance or farm loan waivers or universal basic income which helps citizens to have higher disposable incomes and hence lifts aggregate demand and inflation. Also relaxed norms and domestic manufacturing of commodities can raise core CPi and hence inflation.

Solution D

For Federal Reserves an appropriate policy is expansionary monetary policy by reducing cash reserve ratio, reduced interest rates and buying back government securities through open market operations . Also reduction in statutory liquidity ratio and relaxed lending norms for smaller banks can help boost inflation near target level.